Weekend Reading for Financial Planners (Nov 14-15)

Executive Summary

Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with the SEC’s announcement this week that it is taking a hard (and not very positive) look at RIAs that have outsourced their Chief Compliance Officer (CCO) role, questioning whether an external CCO can realistically be effective at creating a proper compliance culture. Also in the news this week is the announcement that both MoneyGuidePro and eMoney Advisor are soon launching new tools that will allow (new) clients to directly begin entering data into their financial plans, and a study by Deloitte highlighting that while Gen X and Gen Y wealth is on the rise, Baby Boomers will still be the biggest asset gathering opportunity over the next 15 years for AUM advisors.

From there, we have a few practice management articles this week, including: a look at how to hire for advisory firm job positions without scaring away top talent; the importance of having an effective onboarding process for new clients in the first 100 days to ensure they don’t have “buyer’s remorse” after deciding to hire you; and a look at the latest in financial advisor “Deals and Dealmaking” about the factors that are really driving advisory firm valuations in the marketplace (and why the largest firms virtually always command the biggest multiples).

We also have a couple of technical articles this week, from a look at the latest research on predicting which actively managed mutual funds really are likely to outperform, to a discussion of the role that annuities can and should (and shouldn’t) play in retirement income plans, and the importance of making an appropriate assumption about the future equity risk premium for client portfolios (and how to estimate it).

We wrap up with three interesting articles: the first looks at how even though industry analysts all agree that the RIA segment of financial advisors is growing, there is significant disagreement about how many there actually are, with estimates varying from fewer than 6,000 RIAs really delivering personal financial advice to as many as 17,000+ firms with nearly 50,000 advisors; the second is a discussion of how technology and automation are becoming a threat for a wide range of professional services industries (including financial advisors), and how today’s knowledge workers must adapt their valuation proposition to stay ahead; and the last is a discussion of the mega-trends driving the industry in the coming years, from regulatory reform to digital marketing to emerging new revenue models, and what advisors should consider to adapt their own firms to survive and thrive.

And be certain to read to the end and check out Bill Winterberg’s Schwab IMPACT 2015 conference coverage, including interviews with Brian Shenson on Schwab’s technology roadmap, and a 360-degree tour of “The Exchange”, Schwab’s massive conference exhibit hall!

Enjoy the reading!

Weekend reading for November 14th/15th:

SEC Warns Advisers About Outsourcing Compliance (Mark Schoeff, Investment News) – In a new Risk Alert from its Office of Compliance Inspections and Examinations (OCIE), the SEC warned this week against registered investment advisers adopting a “set it and forget it” approach to outsourcing compliance functions. In particular, the SEC is concerned about scenarios where RIAs outsource the Chief Compliance Officer (CCO) role to someone outside the firm, who then inevitably ends out in the dark about the firm’s day-to-day business practices, and may have limited access to its documents and lack regular communication with its principals. The issue, simply put, is that the SEC questions whether such an arrangement would leave the CCO realistically capable of actually identifying and addressing compliance shortcomings, as a sweep of 20 RIA exams with outsourced CCOs found that most could not effectively articulate the compliance issues/concerns of the firm and how they were being managed. Similarly, the SEC also criticized CCOs using “standardized checklists” and outsourced compliance templates that weren’t specifically tailored to the realities of the firm. Notably, the focus of the SEC’s Risk Alert was not that it’s bad to utilize outside compliance consultants to support the development of a firm’s processes and procedures, but simply that ultimately someone internal to the firm needs to maintain a role of compliance oversight and accountability, and be endowed with sufficient authority to actually exercise the role accordingly.

MoneyGuidePro, eMoney Bring Data Entry Directly To Clients (Alessandra Malito, Investment News) – In early 2016, leading financial planning software platforms MoneyGuidePro and eMoney Advisor have both announced that they will be launching tools to make it easier for clients to directly input their own data into financial plans. For MoneyGuidePro, the enhancement will come as a part of its upcoming fourth generation “G4” release, and will allow clients to enter short- and long-term goals, their financial concerns, along with their financial data. In the case of eMoney, the company is aiming to add a sign-up and self-onboarding tool for new clients that advisors will be able to embed into their websites. Notably, both companies emphasize that the purpose of these onboarding portals is not to enable clients to entirely self-direct their financial planning process, but simply to expedite data gathering so advisors can engage in more collaborative financial planning earlier in the process.

Not So Fast! Boomers Still Largest Fee Pool for Advisors (Michael Fischer, ThinkAdvisor) – The Deloitte Center for Financial Services released a report earlier this week entitled “The Future of Wealth in the United States“, which found that while the number of Baby Boomers will decline over the next 15 years due to death, the relatively low mortality rate for those in their 60s and 70s means the Baby Boomer generation will continue to be the wealthiest generation in the U.S. with the largest prospective pool of assets for advisors to manage. Over the same time period, the Gen X share of national wealth is projected to rise from less than 14% today to about 31% by 2030, and Millennials will rise the fastest on a relative basis but still only 16% of national wealth (or barely more than Gen X holds today). Given how slow-motion these trends are anticipated to play out, the Deloitte report suggests that while Millennials shouldn’t be ignored, it may actually be “too soon” for asset managers to make a wholesale shift to focusing on Millennials (at least to provide top-tier AUM-related wealth management services). Or alternatively, to the extent that asset managers and advisors want to seek out working with a wider range of generations, the Deloitte report suggests that service offerings really should be customized to each generation, with older boomers and the silent generation (largely in the mass affluent category) served by seniors-oriented niche advisors, wealthy boomers and Gen X’ers (and maybe a few high-net-worth Millennials) receiving comprehensive planning and wealth management services and products, older Millennials and younger Gen X’ers with a range of “starter” services (e.g., robo-advisor platforms) and a path to provide more comprehensive services to them later, and an advice solution focused around changing saving and spending behaviors for the most debt-laden Gen X and Millennial households.

How To Scare Away New Talent (Caleb Brown, Investment Advisor) – Staff turnover is expensive, as the time and effort to hire and retrain new staff (and the lost momentum along the way) can cost the business as much as 1-3X the team member’s compensation. In addition, for smaller advisory firms, the psychological impact of turnover can be even worse, from the distraction of the advisor business owner, to the adverse impact on the motivation and confidence of the other team members. And of course, a firm with persistently high turnover may eventually have trouble recruiting new talent altogether as the word gets out. Yet while at least some turnover is inevitable, Brown suggests that often advisory firm owners unwitting cause the turnover themselves. For instance, be cautious about just creating a job description based on what the advisor and other staff members don’t want to do (delegating it to the new staff member), or the new person may just end out with an overwhelming volume of disjointed duties (if the list of job responsibilities fills more than a page, it’s too much and needs to be broken up into separate roles). Although at the same time, having a long list of job duties is better than having none, as Brown cautions that the “we’ll-create-it-as-we-go” job description will virtually never attract top talent, as the best candidates want to see exactly what the role will be and the path forward, to decide if it’s a good fit from their perspective. Of course, over time the capabilities of the candidate and the needs of the employee may change… but that’s simply a reminder of why it’s important to have regular reviews with employees as well, to figure out what’s currently working, what’s new, and whether or how the position needs to change to vice the capabilities of the employee (or vice versa)!

Client Relationships: Start With the Future in Mind (John Bowen, Financial Planning) – Despite the fact that it’s so much easier to retain clients than seek out new ones, Bowen notes that advisors spend a great deal of time thinking about how to get the next new client and remarkably little time focusing on how to improve their processes and service for existing clients from the moment after they agree to come on board. In fact, one study found that across all industries, businesses typically lose 20% to 60% of their new customers within just the first 100 days, based on the quality of the service and follow-through they do or don’t provide. The issue is that while initially when clients make a decision to come on board, they experience a moment of relief in the hopes that we’ve found the solution to our problems, but usually not long thereafter the fear, uncertainty, and doubt of “buyer’s remorse” sets in and clients will inevitably begin to second-guess the decision. Accordingly, that’s the exact moment when it’s most crucial to ensure that clients have a good experience. So Bowen actually suggests that advisors focus heavily on the first 45 days of the new client experience, which should include: 1) a formal process of greeting and welcoming the client on board as a new client, reinforcing that it was a good decision to hire you; 2) invite any new client questions and respond to them completely; 3) be proactive in asking about any recent changes in the client’s life at each early meeting (even if little time has passed, you’re communicating what the client can expect about the depth of your involvement in the future); 4) give the client an organizer to help them keep everything in good order as you provide them the various paperwork of the new client process (the financial plan, brokerage/transfer statements, etc.); and 5) do a market recap of how the portfolio has done after the first 45 days, especially if the market is down, to set the context of the long-term focus of the relationship and ensure that new clients don’t use the down market as an excuse to second-guess their decision to work with you. Beyond these steps, Bowen also encourages additional efforts to create client intimacy early on, including sending a short personalized video message, sending a small personal gift, contacting the client via Skype, and mailing a handwritten thank you note. And of course, don’t forget that what you do after the first 100 days to sustain the client relationship is still important, too!

4 Factors for a Fair Deal (Mark Tibergien, Investment Advisor) – The recent Deals and Dealmakers Summit highlighted that while it’s still [popular to talk about advisory firm valuations based on a multiple of gross revenue (e.g., 2X revenue), the reality is that sophisticated buyers really value firms based on a combination of free cash flows (including fair compensation to owners, which may or may not have been accounted for in the past), anticipated growth, and the risks to that cash flow and growth. A review of recent deals also reveals that the sheer size of the firm matters as well, both because larger firms often have some pricing power on their vendors and operational economies of scale, and because larger advisory firms tend to attract larger and more profitable clients, in addition to usually having more capacity to take on new clients as well. Key factors when it comes to risks include the firm’s dependency on a key employee or major client (which again tends to be less of an issue for larger firms, which thus command larger multiples), whether the firms’ advisors are structured into teams that serve the firm’s clients (as opposed to advisors who have their “own” clients in silos), and whether the firm has professional management to ensure its smooth operation even after the founder/owner sells and departs. The fact that many of the largest firms have been most successful at scaling and institutionalizing their marketing processes also supports their greater pricing power. Beyond valuation, the recent Deals Summit also noted that advisory firm merger-and-acquisition deals are becoming more complex and nuanced as firms determine the best ways to find synergies and create new efficiencies, and that while advisory firm deals are becoming bigger, the fact that public market IPOs generally want to see at least a $500M market capitalization means nearly all deals will still be private market cash-plus-stock transactions for the foreseeable future.

What Annuities Can (and Can’t) Do for Retirees (Michael Finke, Research Magazine) – The fundamental challenge of planning for retirement is that while the odds are low that a retiree lives to an advanced old age, there is a chance… and setting money aside for a distant low-probability event can be expensive. For instance, a 65-year-old male has a 10% chance of living to age 96, and if he wants to ensure funding for $100,000 of future-dollar spending in that year, it’s necessarily to put aside $41,200 today into a long-term corporate bond yielding 4% (assuming a 1% advisor fee). By contrast, if 10 people all come together to secure the same goal – recognizing that with only a 10% chance of survival, 9-out-of-10 will be dead by then – together they only need to put in $4,120 each to cover that $41,200 for the 10th person who survives and needs the money. This is effectively the structure of an annuity, and notably in the later years the savings for people to pool their resources together are so significant ($4,120 per person instead of $41,200 “just in case”) that even if the annuity has a moderate cost (e.g., it takes $5,000/person), the retirees are still far ahead by pooling their resources in an annuity. Finke notes that perhaps even better than this arrangement is the use of a variable annuity, which (notwithstanding the fact that they are often mis-sold) potentially allow investors to also retain access to the funds invested, and the potential to earn a risk premium on their investments (in exchange for what is usually slightly less guaranteed income than just using a lifetime Single Premium Immediate Annuity). Although in reality, perhaps the purest form of effective annuitization really is similar to Finke’s example of the 96-year-old – the later the guaranteed payments begin, the more superior the annuity arrangement, which is why various “Deferred Income Annuities” (DIAs, or longevity annuities) appear especially appealing to retirement researchers as a prospective vehicle for funding later-years’ longevity (especially when the annuity is used as a bond alternative).

The Most Critical Planning Assumption – And How To Choose it (Joe Tomlinson, Advisor Perspectives) – Given the long-term nature of financial plans, and the pernicious effect of inflation, the ability to generate long-term growth through the equity risk premium of stocks (the excess return of stocks over risk-free bonds) is essential. Yet as Tomlinson notes, the reality is that the equity risk premium has been very unstable throughout the years. The “common” measuring period from the 1920s until present has enjoyed an equity risk premium of about 6.3%, but with a standard error of 2.3 (which means 95% of the time the equity risk premium is predicted somewhere between 1.6% and 10.9%!); in fact, since the mid-1960s the equity risk premium was only about 4.1%, and from 1792 to 1925 the equity risk premium was estimated at only 2.8%. And in turn, this wide range of equity risk premia impacts not only sustainable retirement income, but also the optimal equity allocation in the first place (which could actually vary from 10% to 80% depending on whether the equity risk premium is at the higher or lower end of the range!). So what should advisors use on a forward-looking basis? Tomlinson outlines a few theoretical approaches, including: assess the demand that investors require for investing in stocks over bonds (which unfortunately is difficult, since the best way to assess is to look at historical results, which as noted have an extremely wide range); collect expert opinions about the future equity premium (which varies almost as much as the historical data!); look at what stocks can realistically supply based on projections of dividend payout rates and dividend growth rates; and assume that the equity risk premium may vary cyclically over time based on market valuation cycles (e.g., Shiller secular bull/bear markets, which would imply a lower equity risk premium in the coming decade given today’s high valuation levels). Unfortunately, there is no definite answer to knowing the future, but Tomlinson emphasizes the importance of having some process to make the determination and validate your assumption, whatever it may be… and recognize the uncertainty and risks that go along with it.

How Many RIAs Are There? No, Seriously, How Many? (Brooke Southall, RIABiz) – Notwithstanding the ongoing industry buzz about the growth of the RIA channel, Southall notes that while we have some pretty good numbers for how many people are in the US, and how many people are practicing doctors, accountants, and lawyers (and any other licensed/accredited professional), there is remarkably little good data about how many financial advisors work in an RIA firm. For instance, the 2015 Evolution Revolution study from the Investment Advisor Association estimates 11,473 SEC-registered advisors (up 578 from last year) managing $66 trillion, but since the IAA represents advisors it wants the number to be as big as possible, which means it throws in almost every possible combination of hybrids, hedge fund managers, wirehouses, institutional advisors, robo-advisors, and anything else that touches RIA status. Once stripped down to the more “pure” independent RIA model, one analyst estimates it might only be about 5,600 Federally-registered investment advisers, controlling just over $6T of AUM. Yet another study estimates 12,802 wealth managers with only $2.2T under management. And of course, these studies only include SEC-registered investment advisers; a Cerulli study, trying to estimate independent RIAs and dual-registered, but both those at the Federal and state levels, put the number at 15,800 firms (with $2.4T of AUM). One broad study from RIA In A Box tried looking at all the data in the Meridian IQ database, and found as many as 31,739 SEC- and state-registered RIAs (up a little over 2% in the past year), and the North American Securities Administrators Association estimates that there are as many as 49,000 total investment adviser representatives at all those firms. The bottom line: while the RIA segment clearly seems to be growing by virtually every measure, figuring out how many there are – especially those “truly” doing personal financial advice, and not operating as pensions, institutional managers, etc. – is surprisingly difficult.

How Professional Services Can Disrupt Its Way Out of Automation (Uschi Schreiber, Knowledge@Wharton) – A growing base of research is suggesting that a wide range of professional services jobs will be done by robots or some form of computer automation in the next 20 years, with some areas like tax preparation facing a 99% probability of the automation threat. Ironically, Schreiber notes that while professional services consultants have a long history of helping other companies manage and combat disruption, the challenge now is that the disruption is coming for professional services itself. So what should professional services providers – from consultants to financial advisors – be doing to position for this future? First and foremost is to recognize what technology is most likely to automate anyway, and embrace the change by adopting the technology directly, using it to serve clients better, and find the next value proposition that builds on top of the technology. Second, recognize that the challenge of finding quality talent that can adapt will itself be increasingly difficult, though the good news is that as geographic borders fade with the connectivity of the internet, the opportunity to recruit talent across the country (and the globe) has never been greater. Third, realize that in many cases, the disruption occurs from outside the industry’s core sector, as various services and industries converge upon one another (think Google disrupting Garmin GPS by giving away Google Maps to support its advertising business), so it’s crucial to stay focused on what clients truly want (even if it’s very difficult than what you currently deliver to them). And last recognize that in a world where you can’t necessarily do everything, it’s crucial to figure out what you will directly do and “own” for your clients, and what else can be outsourced away.

In the meantime, if you’re interested in more news and information regarding advisor technology I’d highly recommend checking out Bill Winterberg’s “FPPad” blog on technology for advisors. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read “FPPad Bits And Bytes” on his blog!